It is said that accounting is the language of business. Terms like “cost of goods sold”, ROI, accrual, expense, depreciation, and capitalization are thrown around in the business world every day. Yet, the average business person does not know what these terms mean. For those dealing with businesses, understanding accounting is essential. Here is a brief introduction to the concepts of Generally Accepted Accounting Principles, types of accounting methods, financial statements, and the point of recognition for revenue and expenses:
Generally Accepted Accounting Principles, also known as GAAP
GAAP refers to a body of accounting methods and procedures used in preparing financial statements. The survival of an accounting principle depends upon its acceptability to the preparers and users of the financial statements. GAAP attempts to provide a consistent system of financial reporting in a general business environment that is always changing. Accounting principles may change over an extended period of time to meet the needs of changing situations.
Accounting principles are not universally and eternally true laws awaiting discovery such as the principles in mathematics and science; however, the debates on how best to present financial information make accounting a dynamic profession. While GAAP is not “law” as we know it, it is the standard in the accounting profession.
Types of Accounting Methods
First, there is financial accounting which involves the preparation of financial reports for ‘external’ users; primarily these would be investors and creditors. The objective of financial accounting is to provide external users with the information necessary to make effective decisions. Obviously, there is a need for a high level of uniformity among financial statements of different companies, since these statements are compared and analyzed by investors when making decisions.
In contrast, managerial accounting concerns the preparation of financial reports used by ‘internal’ users, such as management and the Board of Directors.
The objective of managerial accounting is to provide internal users the means to identify, measure, and analyze financial information in order to plan and to evaluate the business entity for the future.
The Balance Sheet presents the financial position of an organization at the end of a specific date. Its purpose is to help predict amounts, timing, and uncertainty of future cash flows. However, the balance sheet does not represent the current value of many accounts on the financial statement because when it is prepared, assets are stated at their original cost or less, not at their current market value. With the exception of receivables and most investment securities, no current values are shown. In all, a balance sheet is a representation of:
- Property = Legal Rights
- Assets = Liabilities + Shareholders Equity
- Investing = Financing
The Income Statement presents the results of the operating cycle of a business over a period of time, generally one year. Net income or profit is measured as the difference between revenue and expense.
Revenues measure the inflows of assets from selling goods and providing service to customers. When inventory is sold to customers, the cash received from the customers, or the promise to pay (Accounts Receivable) is classified as a revenues stream.
The Cash Flow Statement combines income statement and balance sheet accounts, but specifically avoids the inclusion of any non-cash items such as depreciation. The statement of cash flows takes the cash transactions into consideration by dividing a company’s activities into operating, investing, and financing activities and shows the principle inflows and outflows of cash from each of these activities.
While this Advisory barely scratches the surface of accounting, it does demonstrate a very basic background of terms and concepts. As a former educator I would encourage any officer or director to further their knowledge in the study of the numbers behind business. Understanding accounting concepts makes for a better business person. If you would like to know more about accounting resources which can be helpful, please contact The Center at (618) 997-3436.
By: Roman Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors